KOREA CAPITAL MARKET INSTITUTE

In June 2024, South Korea will issue Korea Savings Bonds (KSBs). After the 2-year Korea Treasury Bond in 2021 and the 30-year KTB future in February in 2024, this adds another new product to Korea's government bond market. The institutional framework for KSBs was established by the amendment on the State Bond Act in April 2023. Concrete rules on the operation have been developed since the amendment on the enforcement decree and rules on the State Bond Act in September 2023. The Ministry of Economy and Finance already enacted the Regulations on the Issuance and Redemption of Korea Savings Bonds (MEF Notice No. 2023-45) to provide concrete guidelines on product features and operation rules. The actual issuance is set to begin in the first half of this year. 

KSBs aim at broadening the demand base of government bonds and also providing the public a means of stable investment. A wider demand base of government bonds is necessary for giving stable support to the government's fiscal policies that have been on the steady rise. Diversifying the demand base from domestic financial institutions to individuals could help the government bond market to grow stably. In addition, as aging progresses, there is increasing need for providing a stable means of investment for helping individuals to build mid- to long-term assets in preparation for their retirement years. Although risky assets such as equity could be an option, there is also a strong demand for safe instruments that provide higher returns than bank savings. The introduction of KSBs came as a result of the long process aimed at improving the economic realities facing South Korea. This article overviews the key features of KSBs, which will be introduced in the first half of the year, and provides a comparative look at overseas cases. It also explores the implications of those bonds and their future impacts on the market.


Key features of KSBs

KSBs are a type of government bonds that can be purchased only by individual investors.¹⁾ Ordinary government bonds have no restriction on investor type and thus could be purchased by anyone including institutional and retail investors. By contrast, KSBs are sold only to individual investors. Any individual who wants to buy the bond must open a designated account (one account per person) at a sales agency, and purchase the bond via that account only. The minimum purchase unit is KRW 100,000, and the purchase can be increased by an integer multiple of 100,000 won. The annual purchase cap is KRW 100 million won.

An important product feature of KSBs is that their trade is prohibited.²⁾ Unlike other government bonds that are traded in the secondary market, those bonds cannot be transferred to other parties or used as a security interest such as pledge. However, exceptions are allowed in the case of inheritance, bequest, and forced execution. KSBs have two maturities: 10-year, and 20-year.³⁾ Unlike regular government bonds which pay regular interest payments before maturity, KSBs do not pay any interest until maturity and then pay a lump sum of principal and interest on the maturity date. The issuance cycle is scheduled 11 times a year, with par issuance on the 20th of each month from January through November. However, no issuance occurs in December for reasons such as managing the issuance cap. Given that this is the first year of issuance, the annual issuance volume is expected to be amount to KRW 1 trillion in 2024, but gradually increase according to demand. 

The issuance is via subscription⁴⁾ by a sales agency, and the MEF recently selected Mirae Asset Securities as a sales agency via open competitive bidding under the Act on Contracts to Which the State is a Party. The subscription period is from 5 to 3 business days before the issuance date, and the subscription time is from 9:00 to 15:30 every business day. However, the subscription period may be adjusted taking into account financial institution closures or legal holidays. Individuals who have a designated account may apply for subscription of the bond via bank tellers or online platforms of the sales agency. It is possible to withdraw or change the subscription within the subscription period. The amount of purchase via subscription cannot exceed KRW 100 million per person per year, regardless of the type of bonds. Applicants must pay the full subscription amount to the sales agency as subscription margin at the time of subscription. 

Subscriptions are allocated within the monthly issuance limit. If the total amount of subscriptions for each bond type is within the monthly per-type issuance limit, all of the subscriptions are allocated. If the amount exceeds the limit, the base amount of KRW 3 million is allocated first to all applicants. However, applicants whose subscription amount is less than the base amount will be allocated the amount they applied for. When the allocated amount surpasses the monthly per-offering issuance limit, the Minister of Economy and Finance may adjust the base amount in units of KRW 100,000. However, if the base amount is lowered to KRW 100,000 but still exceeds the limit, the offering is allocated through a lottery system. The remaining amount within the monthly limit after the allocation is allocated in proportion to the the amount of each subscription minus the base amount. But the amount of less than KRW 100,000 will be rounded off. Any remaining amount within the limit after all the allocation processes can be carried over to the next month regardless of the bond type. 

The issuance procedures described thus far can be summed up in Table 1.
 
As KSBs aim at encouraging individuals to accumulate mid- to long-term assets, substantial benefits are given to those bonds if held to maturity. The benefits can be divided into bonus spreads and tax benefits. If held to maturity, KSBs provide investors a bonus spread in addition to the coupon rate that is determined at issuance. The interest in this case is calculated by applying annual compounding to the sum of the coupon rate and the spread. The coupon rate is determined by the highest successful bid rate for the same issue in the previous month. The spread is determined every month by the Minister of Economy and Finance, who takes into account fiscal demand and government bond market conditions.⁵⁾ Moreover, KSBs held to maturity are given tax benefits such as a 14% separate taxation on interest income from the purchase up to KRW 200 million. Such benefits exist because the middle and working class investors in those bonds may be subject to comprehensive taxation on financial income as the bonds' lump-sum interest payment at the year of maturity could exceed the threshold of KRW 20 million. However, it is worth noting that both bonus spreads and tax benefits are applicable only to held-to-maturity bonds, and they are not allowed if investors redeem their bonds before maturity. Investors who redeem their holdings before maturity will receive simple interest at the coupon rate without the bonus spread, and the interest income in that case is not taxed separately from income. The bonus spread and tax benefits are allowed for a person who holds the bonds as a result of inheritance, bequest, and forced execution. However, the benefits are not provided if the person is a corporate body or an organization. Although investors can apply for early redemption one year after the purchase, they should fully understand that the interest and tax benefits are not available in that case. Applications for early redemption are accepted within the monthly redemption limit, and the payment is made on the 20th of each month. The application may be closed early if the redemption limit is reached.


Overseas cases for government bonds for retail investors: The cases of the US and Singapore

Some of the developed nations such as the US, Japan, Singapore, and the UK have adopted the regime for retail-only government bonds. Among them, this article explores the cases of the US and Singapore, which have become the model case for KSBs. The US is the first country to introduce government bonds for retail investors by issuing the first Series A bonds in 1935 during the Great Depression. Currently, there are two types of US Treasury securities that could be invested only by retail investors: Series EE, which pays a fixed interest rate; and Series I, which pays a variable interest rate indexed to inflation. The maturity of Series EE is 30 years, and the interest rate is disclosed semiannually on the Treasury Direct website on May 1 and November 1 of each year. The interest rate of Series EE bonds that is set at the time of issuance hovered around 0.1% for a long period of time prior to the COVID-19 pandemic due to the low-rate environment. However, it currently is 2.70% as of February 2024 due to the sharp increase in market rates since 2022. Another important feature of the Series EE bond is its guarantee of a 100% return if investors hold the bond for 20 years after issuance, regardless of the interest rate at the issuance. This creates a strong incentive for holding the bond for 20 years or longer. With its 30-year maturity same as Series EE, Series I pays a fixed interest rate and a variable rate based on inflation. As of February 2023, Series I bonds are currently paying 5.27% annual interest, of which 1.3% is fixed and 3.97% is inflation-adjusted. The fixed rate of Series I is disclosed on May 1 and November 1 of each year, which is the same as for Series EE. The interest rate disclosed at issuance will apply until maturity. Both Series EE and Series I receive the same treatment in terms of tax benefits, interest payments, and early redemptions. Interest income from both bonds is subject to federal income tax but is exempt from state and local income tax. Although both of them are redeemable before maturity, any redemption by investors within the five-year holding period is subject to a penalty of no interest for the last three months before the redemption. 

Unlike the US which has long issued government bonds for retail investors, Singapore began issuing them only recently in 2015. Its government bonds for retail investors are issued in 10-year maturity only. Similar to Korea, their transfer is not allowed except in special circumstances, such as the death of the bond owner. It is prohibited to trade those bonds in the secondary market, or to use them as collateral. The government issues those bonds once a month or 12 times a year. At the beginning of every month, it discloses the subscription period, subscription amount, and interest rates depending on the holding period. The subscription is then allocated to applicants based on their subscription amount at the end of each month, and the bonds are issued in the following month. In order to encourage investment in government bonds for retail investors, interest income from those bonds is tax-exempt. Due to the tax exemption on interest income, there is a S$200,000 cap on the size of holdings per individual, regardless of the purchase period. No penalty is imposed on early redemption. One of the important features of government bonds for retail investors in Singapore is the "step-up" interest payments, meaning that the rate of interest paid gradually increases over time to ensure that their yield over a holding period is in line with the level of the government bond yield maturing in the same period. As a result, an individual who buys a 10-year government bond for retail investors will receive interest payments at a higher rate in the second year than the rate paid in the first year. Such a calculation method is designed to ensure that interest payments increase monotonically over a holding period even if the yield curve inverts in the bond market. Unlike KSBs, there is no bonus spread for held-to-maturity securities. Nevertheless, Singapore's step-up calculation method acts as a strong incentive for investors to hold the bonds to maturity.


Introduction of KSBs: Market impacts and implications

KSBs aim at broadening the demand base for government bonds and providing a stable investment means helping individuals to accumulate mid- to long-term wealth. The issuance of KSBs is expected to facilitate more individuals to hold government bonds and thus to strengthen the capital market's fiscal financing function. The market is forecast to grow at a moderate pace at the nascent stage. Thanks to the various benefits, the market appears to enjoy steady inflows of funds even during periods of volatile market rates. Although the issuance scale is not large, securing a stable demand for government bonds holds significance for fiscal financing. 

What's also important on top of the increased demand is to help citizens to build mid- to long-term assets. KSBs, if held to maturity, are equipped with a strong incentive scheme such as a bonus spread, compounding interest, and tax benefits. As of the end of February 2024, the market interest rates of 10-year and 20-year KTBs hover around the 3.4% range. With the bonus spread, the interest rate of held-to-maturity KSBs is expected to reach 3.5%. Given that the interest rate of cash management accounts, a type of checking accounts, is 3.5% and that of one-year savings deposit is 4%, KSBs and the tax benefits could create a significant incentive to hold those bonds to maturity. Their interest rates and tax benefits are competitive even compared to other safe financial products. 

The impact of those bonds' interest calculation via bonus spreads and compounding is especially more pronounced in long-term investment. If you invest KRW 100,000 in a KSB and hold it for 10 years at a final interest rate of 3.5% including the bonus spread, the sum of principal and interest will be KRW 141,060. This equals to 4.11% in the annual simple interest rate over 10 years. If the holding period is extended to 20 years at the same interest rate, the sum of principal and interest will amount to KRW 198,979. That is 4.95% in the annual simple interest rate for 20 years. During the holding period of 20 years, the interest income for the first decade will be KRW 41,060, while that for the second decade is KRW 57,979, which is KRW 16,859 higher than the first decade. Hence, the decision to invest in those bonds should be made from the perspective of long-term investment. 

Thanks to the various benefits, KSBs are expected to attract investor attention if introduced. KSBs are issued by the government, and thus are quite safe with principal protection. It is very unlikely that investors suffer from investment losses. Investors are advised to make an informed investment decision after fully understanding that early redemption deprives them of all the benefits such as bonus spreads, compound interest, and separate taxation. Because early redemptions are allowed up to a preset limit and may be closed earlier than expected, investors may not be able to apply for redemption in that month. There is also a possibility that investors may not be able to purchase as many bonds as they want because subscription is allocated within the preset issuance limit. The aspects mentioned above should be fully taken into account when investors decide to make a decision to buy those bonds. It is also crucial that the sales agency notifies investors of those concerns during the distribution process. 

The introduction of the new bond is expected to have a significant impact on the government's fiscal financing behavior as well as investors' asset accumulation pattern. The government will be able to secure a less-volatile, stable source of financing while retail investors will benefit from a stable and attractive means of wealth management in the long run. It is wise to manage the regime for KSBs in a consistent manner that minimizes trials and errors at its nascent stage, ensuring that it helps retail investors to secure their retirement income from the long-term perspective. 
 

---

1) Paragraph (1) 1 (b) under Article 4 (Types of State Bonds) of the State Bond Act
2) Paragraph (3) under Article 9 (Transfer of Registered State Bond) of the State Bond Act
3) Paragraph (1) under Article 4 (Types of Bonds) of the Regulations on the Issuance and Redemption of Korea Savings Bonds 
4) Article 8 (Subscription Method) of the Regulations on the Issuance and Redemption of Korea Savings Bonds
5) Paragraph (1) and (2) under Article 5 (Interest Rates) of the Regulations on the Issuance and Redemption of Korea Savings Bonds